Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums

Abstract

Using a novel and comprehensive dataset, we provide the first systematic study of liquidity in the foreign exchange (FX) market. Contrary to common perceptions, we find significant variation in liquidity across exchange rates, substantial costs due to FX illiquidity, and strong commonality in the liquidities of different currencies. We analyze the impact of liquidity risk on the carry trade, which is a popular trading strategy that borrows in low interest rate currencies and invests in high interest rate currencies. We find that low (high) interest rate currencies tend to offer insurance against (exposure to) liquidity risk. A liquidity risk factor has a strong impact on daily carry trade returns from January 2007 to December 2009, suggesting that liquidity risk is priced in currency returns. Finally, we provide evidence that liquidity spirals may trigger these findings.

Keywords: Foreign Exchange Market, Liquidity, Commonality in Liquidity, Liquidity Spiral, Liquidity Risk Premium, Carry Trade

JEL Classification: F31, G01, G12, G15